Economist, Telegraph Columnist, Broadcaster

Raise rates now or risk far more pain later

UK inflation was apparently just 1.6pc during the year to March. That’s a four-year low. The Consumer Price Index has now fallen for six consecutive months – the first time that’s happened since the CPI inflation measure was introduced in 1997.

For more than five years, stubbornly high inflation has coincided with job market weakness and a related fall in earnings. As a result, average real wages have plunged by around 10pc, the most severe squeeze on post-inflation pay in this country for more than half a century.

That’s why there’s much excitement in political circles that rock-bottom inflation is now coinciding with faster nominal wage growth. After increasing by 1.4pc and 1.5pc in 2012 and 2013 respectively, average earnings rose by 2pc year-on-year during the three months to February.

So, with earnings now growing faster than prices, real wages are on the up, causing some to declare that Britain’s “cost of living crisis” is over. No matter that, post-inflation wages remain far below their level before the 2008 financial crisis and aren’t forecast fully to recover until 2018. No matter, either, that once you subtract bonuses, which are paid to very few of course, earnings growth is just 1.4pc, still lagging inflation despite the glowing headlines.

It’s entirely false, in my view, to claim that the cost of living crisis is no longer with us, and not only because a single month of rising real earnings is very different from a return to actual pre-crisis wage levels. It’s also important to consider the large (and growing) perceived discrepancy between official inflation and price rises experienced in the real world.

The Office for National Statistics seems consistently to understate price pressures faced by companies and (especially) households. The CPI, for instance, doesn’t include council tax rises, asset prices or housing cost inflation, all of which are high and look set to go higher. Then there are statistical wheezes such as goods-basket rigging, “hedonic benefits” and (take my word for it) the selective use of geometric rather than arithmetic averages.

It’s disturbing, too, that government bean-counters last year declared that the far more accurate Retail Price Index, an inflation measure since 1947, would “no longer be designated as a national statistic”. Could that be because it produced higher numbers than the CPI in 15 of the 16 years since the CPI was introduced?
While real wage levels have yet to recover, though, it is clear the UK economy is now growing rather quickly – largely due to a juiced-up housing market and a sharp rise in consumer debt. Our GDP expanded by 1.7pc last year, faster than any other G7 nation. This year, too, we’re set to out-strip the other advanced economies, with the International Monetary Fund upgrading its 2014 UK growth forecast to 2.9pc earlier this month.

According to the Bank of England, the British economy will grow even faster. This year we’ll see a 3.4pc expansion, says the Bank, followed by growth of 3.2pc in both 2015 and 2016, all of which sounds great. But if the Monetary Policy Committee really believes these rosy above-trend forecasts, why isn’t it increasing interest rates?

The official reason, of course, is that MPC members are worried about snuffing out the UK recovery by raising interest rates too early. The unspoken reason is that we’re now deep into the electoral cycle and the government doesn’t want a rate hike before the general election in May 2015.

OK, I get all that. And during this sunny Easter weekend, it may seem churlish to broach difficult subjects. The MPC, though, has kept UK interest rates at their record low of 0.5pc since March 2009. That was an emergency setting for an emergency situation that, for now at least, is clearly no longer the case. It seems pretty obvious that the UK economy is now in danger of over-heating if rates aren’t raised over the next six months, so unleashing a new boom-bust cycle, resulting in a return to stagnation in several years’ time.

Given that it usually takes at least a year for interest rate changes to feed through into real economy activity, and perhaps longer to impact inflation, it is crucial that the MPC looks forward. It strikes me that if nothing is done to take the edge of this boom pretty soon, then wage growth could become a problem, feeding into high inflation.

Consider, also, that the low inflation number in March, while eye-catching, was largely driven by petrol prices that were unchanged on February, compared with a sharp monthly rise of 2.2p a litre a year earlier. That’s a one-off. On the futures market, oil prices have surged in recent weeks, rising no less than 6pc so far during April alone. Fuel price pressures are likely to remain high, geopolitical tensions aside, as the global recovery gathers pace.

I’d argue, too, that there’s a lot of inflation “baked-in” to the UK economy as a result of “quantitative easing”. Back in March 2009, we were clearly in a mess. Without some “extraordinary” monetary measures, the UK’s banking system would have seized completely, resulting in economic and social chaos. Yet, the room for manoeuvre afforded by the first £50bn round of QE should have been used to force insolvent banks into administration, while protecting depositors, with shareholders and creditors taking their losses.

QE has instead expanded grotesquely since 2009, to £375bn, being used to mask bank losses rather than increase lending, so allowing essentially insolvent financial institutions to keep trading. As these failed banks slowly return to life, and the bulk of the QE proceeds enter broader circulation as new credit, inflationary dangers will rise. That’s another reason the MPC should take pre-emptive action by raising rates to “normal” levels – a process that should be gradual, yes, but which needs to start now.

The Bank counters that there’s lots of spare capacity in the economy, so inflation will remain subdued. The labour market suggests otherwise. Unemployment is now less than 7pc – below the threshold that Governor Mark Carney suggested would cause the MPC to consider higher rates. Employment is surging, up 691,000 during the year to February and by 240,000 over the last three months. And crucially, job vacancies are now soaring, no less than 21pc higher than a year ago and above 600,000 for the first time since 2008. All that points to rising wage pressures, if the current momentum is sustained.

Many readers will grumble that low UK interest rates are anyway a myth. Rates are low for banks, but relatively high for commercial borrowers, with most businesses, especially SMEs, having to pay at least 5pc for credit. While that’s true, it remains clear that the current rate-setting, combined with the government’s absurd “Help to Buy” scheme, is juicing up the housing market to a dangerous degree. House prices are up 9.1pc across the UK over the last year and a ridiculous 17.1pc in London. And where house-price inflation goes, the rest of the economy usually follows.

Higher rates could push up sterling, of course, making life more difficult for UK exporters. That would do little to address our record trade gap – and I accept that’s a risk. There’s a greater risk, though, that if we don’t increase rates “ahead of the curve”, then they’ll eventually have to go up further than they otherwise would – resulting in far more pain for debt-soaked firms and households. There are few clear trends in economics, but that’s one of them.